Interest Rate Divergence – July 2005

July 25, 2005
Dow Jones Average: 10,651
S&P 500: 1,234


Interest Rate Divergence


By raising or lowering interest rates, the Federal Reserve Board attempts to modify or reverse prevailing trends in the economy and financial markets. While economic activity is affected by changes in interest rates, there are other factors that can offset a modest change in rates. Changing the behavior of investors and consumers often requires a persistent, significant change in rates by the Federal Reserve.

Since 1998 the Fed has dramatically shifted its interest rate policy four times. In late 1998 the Fed cut rates sharply to prevent a possible economic recession in the wake of the Asian currency and debt crisis. Two years later the Fed pushed rates up to nearly eight percent with the intention of cooling off the greatest stock market bubble in U.S. history. That policy position was quickly reversed after the stock market collapse of 2000-2002. The Fed reduced rates thirteen times to a sixty year low of one percent, hoping to prevent an economic meltdown caused by malaise over stock market losses. The extraordinarily low rates touched off a real estate boom that has forced the Fed to once again shift course on interest rates. The nine rate increases of a quarter point each since last summer have been engineered to gently slow the pace of real estate price appreciation.

The steady, year long rise in short term interest rates has had little impact so far on the real estate market. By raising what is called the Fed Funds rate, the Federal Reserve Board immediately affects the yield on treasury bills, short term C.D’s, the prime lending rate at banks, and other limited duration debt instruments. The Fed has little to no control over intermediate and long term bond rates, which are set by the buyers and sellers of such bonds. If enough investors are willing to accept a low rate of return on ten year treasuries, the rate on such bonds may remain low even as short term rates climb. For some reason rates on ten year and longer paper have fallen to around four percent even as short term rates have moved from one percent last summer to 3.25 percent today. The nine Fed rate hikes since summer 2004 have had virtually no impact on the real estate market, because mortgages are based on the ten year or thirty year bond rates which have actually moved lower since the summer of 2004.

No one seems to know why the short term and long term rates are moving in opposite directions. Alan Greenspan has called the divergence in interest rates a great “conundrum” that is confusing economic policy makers around the globe. The staff of economists employed by the Federal Reserve Board analyzed various factors such as capital inflow from the Far East, pension funds moving to bonds as baby boomers approach retirement, and possible fear of economic weakness ahead. After much study they concluded that these factors do not explain the mysterious, unprecedented divergence in rates.

In our opinion, the Fed wants the ten year bond rate to move up to a higher level, probably close to five percent, so that cheap money is not so available for real estate speculation. While the Fed can not directly set the ten year bond rate, they can keep raising shorter term rates, and eventually that may draw investors away from the longer term paper. The longer the Fed has to persist with rate increases to succeed in its mission of cooling real estate speculation and other inflationary trends, the more pressure will build on stock market valuations.

Current Strategy

Corporate earnings are clearly benefitting from a stronger selling environment and profit margins that are near record levels. Strength in real estate has filtered to many sectors that are involved directly and indirectly with home building and financing. Despite the better results being reported by numerous companies, the stock market has remained locked in a tight range, little changed from its year end 2004 level. Investors are troubled by steep oil prices and increasing interest rates. The fear is that consumer demand may wilt in the face of higher energy bills and higher financing costs. If the economy slows, profit margins will most likely shrink from the current record levels.

We are continuing to selectively buy new positions in companies that have shown resilience during periods of economic weakness. The medical, insurance, and software sectors are the kind of businesses that have achieved consistent growth in almost all economic environments. While favoring such traditional growth sectors recently, we are also maintaining positions in the more economically sensitive stocks bought over the past two years. If the climb in oil prices and interest rates stops, investors may have renewed enthusiasm for the more economically driven companies. By maintaining most current holdings, and adding new ones, we are increasing overall portfolio exposure to stocks.

Our bond strategy is very simple. We are keeping much of our clients’ fixed income funds in short term treasuries, rolling these treasury bills every few months to capture the latest interest rate increases. We are staying clear of intermediate and longer term taxable bonds, because these bonds could lose significant value if and when intermediate rates move to five percent. We are buying tax-free municipal bonds for certain accounts, usually as replacement for bonds that have matured or have been redeemed by the issuer.

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